Effective Regulation - Part 4: Turning Good Ideas Into Good Outcomes

Oct 2009Source: Global Markets Institute

The fourth installment in our series on effective regulation

No idea is so good that it can’t be misapplied

Efficient and safe financial markets are essential to global prosperity. The goal of regulation should be not only to make the financial system safer, but also to improve its ability to perform its two critical functions: allocating capital to where it will best be utilized, and providing individuals with the opportunity to participate in markets in an equitable fashion.

Many good ideas aimed at reducing systemic risk and improving fairness for all market participants are now under consideration. But good ideas do not necessarily guarantee good outcomes. Execution and application matter. Securitization is an excellent example of how a good idea, when applied badly, can go terribly awry. In response to earlier banking crises, securitization was embraced as a means to reduce risk at individual banks. It worked – local banking problems became fewer and more easily managed. But when securitization was applied to low-quality assets and improperly used by banks to exploit gaps in regulatory oversight, it helped to create the current crisis.

Actions taken in one area can have profound and sometimes adverse effects on another – in ways that are not always obvious beforehand. This is often referred to as the “law of unintended consequences”. As we consider changes to the regulatory system, it is important to understand how these changes may have impacts beyond what is intended.

In this piece, the fourth in a series on effective financial market regulation, we aim to help better focus the debate on financial reform beyond individual issues and to look instead at how the whole system can be altered to reduce systemic risk and improve overall economic performance. We concentrate on a few key topics: the role of market-makers in resolving mismatched markets; the importance of full participation in the price-discovery process; and the most effective role for clearing houses. In looking at each, we consider how the whole financial system can be strengthened without inadvertently sowing the seeds of the next crisis or significantly diminishing market efficiency.